Taxation (Annual Rates, Taxpayer Assessment and Miscellaneous Provisions) Bill

Taxation (Annual Rates, Taxpayer Assessment and Miscellaneous Provisions) Bill

Officials’ Report to the Finance and Expenditure Committee on Submissions on the Bill

13 August 2001

Prepared by the Policy Advice Division of the Inland Revenue Department

and the Treasury

CONTENTS

Interest deductibility

Interest deductibility – overview

Timing application

Issue:Effective date of core interest deductibility proposal

Issue:Timing of interest deductions

Definition of “company”

Issue:The deriving of tax-exempt income from treasury stock

Issue:The timing of deriving gross income

Issue:Non-resident companies

Drafting issues

Issue:Override of the exempt income prohibition

Issue:Separate provision for interest rules

Issue:Renumbering of section DD 1

Interest deductions for partnerships

Research and development

Research and development ( R&D) – FRS 13 proposal

Inconsistency between draft legislation and explanatory note

Reference in Income Tax Act to FRS 13

Issue:Incorporation of FRS 13 into the legislation

Issue:Accounting principles should not be imported into the tax law

Option to use current law or new rules

Following FRS 13 in its entirety

Application of paragraphs 5.14 and 5.15 of FRS 13

R&D carried out by or on behalf of a taxpayer

Materiality

Issue:Immaterial expenditure should be immediately deductible

Issue:Adjustments for tax purposes where financial reports reflect principles of materiality

Simplified rules for small taxpayers

Inland Revenue’s policy statement on the tax treatment of software

Unit trusts: transfer of expenses proposal

Unit trusts – overview

Broadening the scope of the legislation

Issue:Transfers to a 100% owned wholesale unit trust

Issue:Application to other entities

Issue:Imputation credits

Issue:Change of investment

Legislative certainty

Issue:Timing of dividend exemption

Issue:Removal of the dividend exemption

Issue:Gross income of the first unit trust

Issue:Deductible expenditure of second unit trust

Issue:Cost price and available subscribed capital

Issue:Exclusion from gift duty

Transferable expenditure

Issue:Nature of transferable expenditure

Issue:Information required to transfer expenditure

Issue:Scope to reject transfer of expenditure

Timing of expense transfer

Issue:Expenditure incurred in same year

Issue:Time when second unit trust deducts

Elections

Issue:Notice of election

Issue:Time limit on election

Deduction balance formula

Issue:Non-resident withholding income

Issue:Excess imputation credits refunded

Issue:Denial of unused expenditure

Issue:Allowing for adjustment

Issue:Whether the first unit trust should be able to deduct the unutilised transferred expenditure under ordinary rules

Technical amendments

Unit trusts: unit-holder continuity rule and definition of
qualifying unit trust

Definition of “qualifying unit trust”

Issue:Temporary holders of greater than 10% in unit trusts with over 100 unit-holders

Issue:More than one type of investor

Issue:Associated person test

Issue:Non-qualifying unit trusts or high net worth individual members of qualifying unit trusts

Issue:Clarification changes

Issue:Clearing houses that dispose and acquire on behalf of unit trust investors

Special corporate entity status

Look-through rules

Section OD 5(4A) application criteria

Drop-in/drop-out provision

Section OD 5(4A) concessional treatment

Reference to units

Prohibition of group loss offsets

Section GC 22A – a new imputation anti-streaming rule

Unit trusts: imputation credit streaming

Unit trusts: imputation credit streaming

Transfers of overpaid tax

Transfers of overpaid tax

Link with use-of-money interest rules

Issue:Additional provision linking amendments with use of money interest rules

Issue:Publication of effect of amendments in Tax Information Bulletin

Requests for transfer

Issue 1: Taxpayer who satisfies criteria to contact Inland Revenue following enactment

Issue 2: Additional circumstance in which provision should apply

Issue 3: Provision should apply where no request because of earlier refusal

Roll- forward of tax through subsequent years

Other changes to Income Tax Act 1994

Attribution rule

Issue:The attribution rule and double tax

Issue:Technical issue where the intermediary (person B) is a trust

Definition of “associated persons”

Minor remedial amendments to Income Tax Act 1994

Taxpayer assessment

Taxpayer assessment – overview of submissions

Transfer of depreciable property between associated persons

Market value

Issue:The meaning of market value

Issue:Leases for inadequate rent

Amending exceptions to time bar

Whether adjustments for incorrect accounting practice should be treated
differently from other adjustments

Issue:The extent adjustments for incorrect accounting practices should be allowed – section EC 1

Issue:Proposed definition of “cash accounting method” – section EC 1

Residual discretions maintained by Commissioner

Issue:Allowing taxpayers to self-assess remaining Commissioner discretions

Issue:Retention of Commissioner discretion in section LB 2(5)

Removing Commissioner discretions

Issue:Drafting of amendment to section DF 2

Issue:Section DL 1(11) – cost of timber determinations

Issue:Drafting of section DN 1(8)(c) amendment

Issue:Drafting of section HF 1(4)

Issue:Section KC 1 – low income rebate

Issue:Location of new section KD A1

Issue:Use of “reflected” terminology

Issue:Identifying definition to which amendment is made

Issue:Certain rights of challenge not conferred

Issue:Replacing alteration references

Scope of the Bill

Issue:Taxpayer assessment as part of the Rewrite of the Income Tax Act

Issue:GST and self-assessment

Minor amendments

Issue:Definition of “notice of proposed adjustment”

Issue:Default assessments

Issue:A purpose provision in relation to taxpayer assessment

Issue:A return as a “notice of self-assessment”

Issue:Section 80H

Issue:Definition of “assessment” in relation to the Tax Administration Act

Issue:How time limits apply to an assessment that includes losses

Issue:The two-month period for taxpayers to propose adjustments to their self-assessments

Issue:Whether taxpayers should be able to fix a date of self-assessment

Issue:Section 89C

Issue:New section 89D(2)

Issue:New section 89DA

Issue:New section 92

Issue:What happens when the Commissioner calculates rebates of income tax

Issue:Minor amendment to new section 33(1)

Issue:Minor amendment to section 177(4)

Minor associated amendments to the Child Support Act

Issue:Amendment to the definition of “taxable income”

Issue:Application of assessment

Changes to GST Act (except for changes included after
introduction of the bill

GST on tokens, stamps and vouchers

Issue:Amendment to section 5(11G) of the GST Act

GST on supplies to visiting foreign-based pleasure craft

Issue:Definition of ‘consumable stores’

Issue:Zero-rating of particular spare parts to foreign-based pleasure craft

Issue:Removal of definition of ‘consumable stores’

Issue:Time limit required for departure

Changes to other Acts

Amendments to Stamp and Cheque Duties Act 1971

Issue:Drafting issue

Minor remedial amendments to Taxation (Beneficiary Income of Minors,
Services-Related Payments and Remedial Matters) Act 2001

Issue:Correction

Issue:Correction

Minor remedial amendment to Child Support Act 1991

Interest deductibility

1

Interest deductibility – overview

Clauses 5, 21, 62, 63, 65, 92, 95, 107, 112, 157

Introduction

The proposed changes ensure that interest incurred by most companies is deductible, subject only to the existing thin capitalisation and conduit interest allocation rules. The companies affected are all companies other than qualifying companies and companies that derive certain forms of exempt income (for example, charities and local authorities). The bill proposes applying this clarification from the 2001-02 income year.

Two remedial amendments are also being made to overcome any doubt inadvertently created by amendments to the Income Tax Act’s core provisions in 1997. The first amendment is to ensure that the rule that allows companies to deduct interest on borrowings used to capitalise subsidiaries that are at least 66 percent owned is fully effective. The second remedial amendment confirms that interest incurred is generally timed under the accrual rules and is not retimed by any other timing rules in the Act. These remedial amendments are to be backdated to the application of the Taxation (Core Provisions) Act 1996, that is, from the 1997-98 income year.

The bill also makes consequential reference changes affecting sections FG 8, FG 9, FH 5, HB 2, HG 9 and LF 7.

Overview of submissions

Seven submissioners commented on the bill’s interest deductibility provisions. All supported the general thrust to clarify and make certain the rules on the deductibility of interest, acknowledging the compliance cost savings.

The most common theme in submissions related to the application dates of the proposals.

Timing application

Issue:Effective date of core interest deductibility proposal

Clause 21

Submission

(3 – Rudd Watts & Stone, 7 – Corporate Taxpayer Group, 9 – Deloitte Touche Tohmatsu, 8 – Institute of Chartered Accountants of New Zealand, 4 – New Zealand Law Society)

These submissions propose that the core interest deduction proposal:

• be made retrospective to the 1996-97 income year, when the thin capitalisation rules became effective (Rudd Watts & Stone and New Zealand Law Society);or
• be made retrospective to the 1997-98 income year, when the core provisions became effective (Deloitte Touche Tohmatsu, and Corporate Taxpayer Group); or
• should extend to all open year tax returns (Institute of Chartered Accountants of New Zealand).

Comment

Notwithstanding that from a policy perspective it is agreed that interest incurred by companies should be deductible, submissioners wanted to ensure that there would be no dispute about past interest deductions, given the uncertainty surrounding the application of the existing law. This uncertainty has been increased by the two issues papers on interest deductibility circulated by Inland Revenue’s Adjudication and Rulings division. Submissioners have, therefore, proposed that the application of the new rules should be backdated.

We accept that there are grounds for backdating the core proposals to increase certainty. Not doing so runs the risk of structures previously thought valid being overturned. Any past date is arbitrary. However, it seems that accepting the suggestion of going back to the start of the 1997-98 income year, when the core provision changes took effect, is appropriate. It would cover the period of four years in which the Commissioner could normally reassess a taxpayer’s position.

We believe there is little, if any, fiscal, compliance or administrative cost associated with this retrospectivity. However, the certainty gained by taxpayers appears to be significant.

Recommendation

That the core interest deductibility rule be made retrospective to the 1997-98 income year, when the core provisions of the Income Tax Act were made effective.

Issue:Timing of interest deductions

Clauses 62, 63, & 65

Submission

(3AW – Rudd Watts & Stone)

The proposed rule to ensure that interest expense as timed by the accrual rules is not retimed by any other timing rule (such as the revenue account property rule) should not be retrospective and should not apply to proposals for which commitments have been made, particularly in relation to film expenditure.

Comment

Following the rewrite of the Act’s core provisions, which took effect from the 1997-98 income year, it has been arguable that interest associated with a project is a cost of that project and, therefore, is not deductible until the income from the project is realised. As we understand it, general taxpayer practice is to deduct interest as a period expense, in the period in which it is timed by the accrual rules. The proposed amendment in the bill confirms this practice and is, therefore, taxpayer-friendly as it removes any doubt about having to defer the deduction.

From a tax policy perspective, interest should be regarded as a periodic expense, not a project cost, as the project's value does not vary merely because it is debt financed rather than equity financed. In any case, as the Government discussion document on interest deductibility points out, it is frequently not possible to trace borrowings and, therefore, interest expense to their end use. Thus rules which would regard interest as a project expense would largely be ineffective.

Backdating the change is necessary to ensure that past treatment of the interest as a periodic expense is not overturned. Accordingly, the first part of the submission is not appropriate.

The second part of the submission asks that interest that forms part of a film’s cost be excluded from the new rule when commitments have already been entered into. Again, the issue is one of ensuring that when interest has been regarded by taxpayers as a periodic expense, it should not be retrospectively changed. Officials doubt that anyone will be able to offer an assurance that no film-maker has regarded interest as a periodic cost.

However, it seems reasonable that when taxpayers have not regarded, or were not intending to regard, interest as a periodic expense, whether in relation to films or any other type of project, that they should be able to choose to defer the deduction if they want to. Among other things, this will ensure that tax returns do not have to be re-opened when interest has been regarded as a project cost.

Accordingly, taxpayers should be allowed, as a transitional arrangement, to regard interest as a cost subject to the timing rules in the following circumstances:

• if they have filed tax returns on that basis; or
• if in respect of unfiled 2000-01 and 2001-02 returns, they file on that basis.

There seems to be no point in going through a more formal election basis, or requiring them, say, to have a commitment to file on that basis. Almost all taxpayers will be quite happy to presume that interest is a periodic expense. Those that could be adversely affected would, however, have a choice.

Recommendation

That the submission be declined, but when taxpayers have filed on the basis that interest is a project cost, not a periodic cost, that position be grandfathered, and when, in respect of unfiled 2000-01 and 2001-02 returns, they file on a project cost basis, this be acceptable. This arrangement would not be confined to film expenditure.

Definition of “company”

Issue:The deriving of tax-exempt income from treasury stock

Clause 21

Submission

(7–Corporate Taxpayer Group, 9–Deloitte Touche Tohmatsu,10 – PricewaterhouseCoopers, 4 – Institute of Chartered Accountants of New Zealand)

Company taxpayers who derive exempt income from the on-sale of treasury stock should not be excluded from using the core interest deductibility rule.

Comment

Companies are allowed, under the Companies Act 1993, to buy and sell their own shares – when they hold their own shares this is called treasury stock. Tax law makes the sale proceeds exempt income whether the shares are sold at a profit or a loss. The bill proposes that the core interest deductibility rule would not apply when a company derives exempt income other than exempt dividends.

The holding of treasury stock, while not being an everyday commercial event, should not, from a tax policy perspective, cause interest deductions to be limited. Therefore we agree with the submission.

However, the submission raises wider issues about whether there are other forms of exempt income that should qualify. What, for example, if another company in the group of companies derives the exempt income, or if the exempt income is an ancillary part of a taxable business, such as a horse stud deriving race winnings?

From a tax policy perspective, the first question raises significant issues, which we have discussed with the submissioners. The issue is that in a corporate group it is often not possible to trace borrowings to their eventual use. Indeed this is the reason for the proposed core rule. However, the core rule means that one group company can claim the interest deduction while another derives the exempt income. The exempt income limitation on the rule should, therefore, be extended to all group companies when one group company derives exempt income.

The second question can be specifically dealt with. When the race prize money is an ancillary part of a wider associated business, say a breeding operation, the core rule should apply; otherwise it should not.

We have considered all other income that the Income Tax Act exempts and are not concerned that this other income gives rise to any problems.

Recommendation

1.That the submission be accepted;

2.that when prize money is won as an ancillary part of a breeding operation, the core interest deductibility rule should apply; and

3.when a group company derives inappropriate exempt income, the core rule should not apply to any group company.

Issue:The timing of deriving gross income

Clause 21

Submission

(7 – Corporate Taxpayer Group, 9 – Deloitte Touche Tohmatsu)

The timing of the derivation of exempt income needs to be made more explicit by stipulating that the deriving of exempt income is “in the year in which the relevant interest deduction is being taken”.

Comment

Clause 21 stipulates that “a company does not include a qualifying company or a company that derives exempt income, unless all of the exempt income is from dividends”. The submissions are concerned that this wording is too loose. Does the deriving of exempt income in any year result in exclusion, or does the test apply on an annual basis? If the test is not on an annual basis, the submissions suggest that it may be impossible to substantiate that a company will never derive exempt income other than dividends.

Trying to tie the incurrence of interest expense to any particular income stream is not feasible. This is a driving force behind the reforms in the bill that remove the need to link the interest expense to the deriving of income. The same tracing problem arises with exempt income.

The wording in the bill presumes an on-going flow of exempt income, such as with a local authority, in which case whether the test is applied annually or otherwise, the result is the same. But, if the exempt income stream is variable, then the timing aspect becomes important. Our view is that the wording in the draft bill would apply the test to the income year in question, which is what the submissions want to achieve, rather than being open-ended. Therefore the additional wording proposed by the submissions is unnecessary.

Applying the submissions’ argument for the extra wording would mean that other implicit tests in the legislation would need to be qualified by reference to income years. For example, the test of whether an entity is in fact a “company” applies on an income year basis, but the submissions have not proposed additional wording in relation to other tests.